Mike Lipper’s Monday Morning Musings
Capital Cycles Changing?
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
The critical lesson of living we must deal with is that all of life is cyclical. As investing is an abstraction of living, investors must deal with cycles. Our cycles occur along the spectrum of capital, going from capital appreciation to capital preservation or from highlighting goals of success to those of survival. A somewhat parallel spectrum is arrayed between “growth” and “value”, as we choose to define them. It is often useful to determine where we are in the spectrum by relating current values to those at the extremes. The activists believe they can consciously time their movement from one extreme to another, while historians are generally more comfortable mid-range. This dichotomy was evident during the past two weeks.
Where Are We Going?
Far too many words have been written recently giving directional advice without understanding where we are in the investment and market cycles. The distinction between the two related cycles is that investment cycles begin with intelligent and prudent transactions, while market cycles record sudden shift in prices. Somewhat suddenly two weeks ago, “value” stocks and funds began performing better than the prior leaders marching under the banner of “growth”. This past week the momentum in favor of “value” was absent or subdued. This is not surprising as growth has been a consistent winner for ten years and in the first four days of the week transactional volume was low. “It takes a long time to turn a battleship” was one of the lessons taught us in the Naval Reserve Officers’ Training Corps (NROTC).
Is There a Change Happening?
When one is in a turning phase it is almost impossible to be certain of the future direction. Is it a ninety degree, one hundred and eighty degree or three-hundred-and-sixty-degree turn? There are at least four bits of evidence that something out of the ordinary is happening.
- Falling prices have seen more volume than those rising in this week’s transactions. (More dollars are leaving than coming into the market.)
- On Friday there was a surge in the transactions of asset management stocks, e.g. T. Rowe Price (*) traded almost 3 times its average volume of the prior four days.
- High-quality debt yields declined more than intermediate-quality debt based on the latest week’s yields. (Bond prices move inversely to yields, so the desire to own high-quality paper with reduced income is a sign of concern for both bond and stock prices.)
- WeWork’s proposed IPO price, after dropping by two-thirds, was withdrawn. (In the weekend edition of the Wall Street Journal, my friend Jason Zweig intelligently questions the myth that private investing produces better results than publicly traded investments. The significance of this belief is that many tax-exempt institutions and wealthy individuals have put substantial amounts of their capital into private securities, believing that their lack of liquidity and disclosure are exchanged for better performance, often caused by their IPOs. I am familiar with several cases where this didn’t work out.)
What is “Growth” and “Value”
Investors use labels as an abstraction to convey a series of integrated, complex concepts. The essence of “growth”, “growth stock” and “growth stock fund” is the rising of stock prices above those found in the general stock market on a secular basis over multiple market price cycles. This definition ignores both short-term and economic cycle price swings around an upwardly sloping trend line. Another way of expressing this concept is that growth companies have profitable products and services, which are met with increasing acceptance by both customers and investors. There is a problem with that definition in that the label is unlikely to be permanent for all time, due to its dependence on the perceived ranking versus their competitors. However, some companies have appropriately maintained the label for a long time. The trick for investors is to identify when that the label is slipping. Renewed, skeptical analysis is needed.
There are many ways to define “value”, because value is in the eye of the beholder. The original investors were the primary investors betting on the success of the venture. The follow-on investors were cashing out the originals and had to question the offered price relative to other alternatives. The second set of investors thought of value in terms of a discount relative to present prices. The history of Security Analysis is that it was developed as an offshoot to accounting. The original course by Ben Graham and Dave Dodd started with the analysis of the assets behind bonds, which were selling below both their maturity price and the statement value of the assets. We were taught to schedule the cash conversion schedule of the assets. Greater weight was readily given to assets converted to cash, like finished inventory vs. plant and equipment etc. This led to a group of buyers who were labeled “net-net buyers”. Ben Graham, Warren Buffett and the late, great Irving Kahn were some of these.
Because of a much higher level of public disclosure and computer searchable financial statements, there are relatively few net-net opportunities in most developed countries markets. In its place some have used the discount from book value or net asset value for fund vehicles as a substitute. For the most part this has not worked particularly well because balance sheets record historic asset acquisition prices adjusted for annual depreciation and impairment costs. Book values are rarely written up according to accounting and regulatory rules. Recent attempts to capture the discount on closed end funds has not been successful. First, it takes time, effort, and often money to displace the present management. Second, there is likely a difference in price form the last sale at the end of a day and the actual price received in liquidation.
So Where Are the Value Opportunities Today?
There are quite a few that are the equivalent of Sherlock Holmes in the mystery of the dog that didn’t bark. The focus should be on what is not on the balance sheets of both assets and liabilities. One example is real estate for an operating company. Royce & Associates (**) has a fund that invested in Steinway, the concert piano manufacturer, which was not growing. However, uncaptured on its balance sheet was the air rights above its low-level 57th street show room and their large facility in a rapidly changing section of Queens. This proved to be very profitable when the real estate was liquidated. Much like a chain of cigar stores on many prominent corners in Manhattan, which lost money as tastes shifted, but had very long-term leases on their stores.
Today, in many companies the most valuable asset is the lists of customers and what they purchase. Two examples are stocks that I own personally, neither of which I expect to liquidate even though they have understated book values. Apple’s one billion customers names and spending habits proved that an asset could predict future sales, much like when car owners traded in their vehicles every one to three years. Another company that is assembling a combined customer information databank is CVS, which is combining its pharmacy and health insurance customers. Not only are there repeat business opportunities, but the potential to identify new demand as new drugs and services are developed. I suspect Amazon could create the same type of value, which is essentially a derivative of DE Shaw’s ability to predict market prices.
Is There Another Approach?
Believing in cyclicality, I often look at the worst performing investment objectives compared to the best. (This works for a group of funds, but not necessarily for individual funds where differences in skill levels are apparent.) In the last five years the average growth fund of all sizes, both domestic and international, averaged a gain of +7.57% compared to value funds which gained +3.50%, or effectively half. Thus, one can see my initial attraction to the possible shift in favor of value. Even with this instinct when investing new money we are more weighted toward growth for long-term accounts, but we are slowly increasing our exposure to value. The reason for the slowness is that we could still have another strong bull market led by growth. We are very close to record price levels, with the Dow Jones Industrial Average behind -1.55%, S&P 500 -1.12% and NASDAQ -2.55% from their record highs. We are paying attention to the NASDAQ as it is the most speculative of the indicators and is the one that has recently shown significant selling volume.
(**) My son who is the senior investment strategist for Royce Associates and was not involved in that decision.
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